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The City Debate: In This Current Financial Environment, More Financial Regulation Is A Major Part Of The Solution

Securities & Investment Institute
Annual Debate
Mansion House, London
Wednesday, 14 January 2009

“In this current financial environment, more financial regulation is a major part of the solution”


For the motion:
Dr Vince Cable MP
Mr Alan Yarrow FSI

Against the motion:
Professor Michael Mainelli FSI
Mr David Bennett FSI
Chairman – My Lord Mayor, Ladies and Gentlemen.

Chairman:
Mr Christopher Jones-Warner FSI

Text of Professor Mainelli’s response:

[STARTS]

Tonight I am that kid who told you that Santa Claus didn’t exist. More and better regulation is a lie-for-children alongside Santa Claus, the Easter Bunny, Nessie, immaculate conception, evolutionary design and honours-on-merit.

Wikipedia’s definition of financial services regulation “is a set of beliefs and practices, often centered upon specific supernatural and moral claims about reality, the cosmos, and human nature, and often codified as prayer, ritual, and [religious] law”. Oops, that’s Wikipedia’s definition of religion. But financial services regulation is a religion. Recent regulatory failure has created apostates, the worst challenge for a religion, so the establishment is performing the classic redoubling ploy, “regulation failed because you really really didn’t believe enough in regulation. So pray harder.”

Market failure comes in three broad categories: lack of competition, information asymmetry/agency problems, and externalities. Wholesale finance certainly exhibits classic signs of lack of competition: an industry that went from a market capitalisation in the USA of 5% in 1990 to 23.5% in 2007 – a quarter of the US economy is pushing paper around? And self-evidently excessive salaries, a banking industry with 2006 profits per employee a magical 26 times higher than the average of all other industries worldwide (according to McKinsey), and a cast list of the top 10 that would be largely recognisable back in 1929: Goldman Sachs, Merrill Lynch, Lehman Brothers (oops), Morgan Stanley, Bear Stearns (oops), JP Morgan Chase, Citi … mid last year – less than 20 global investment banks, 4 auditing firms, 2 credit rating agencies, 2 actuarial firms. Frank Partnoy covers two decades of scandalous abuse of investment banking customers in nauseating detail in his 2003 book, Infectious Greed – and taxpayers pick up the cost.

When we see market failure we should first try and fix it through trust-busting or anti-monopoly laws or regulation – the 1890s in Britain, the 1900s in the USA. The religious faithful of regulation want to go much further the other way and now seek powers to create and follow mega-banks, rather than question whether size itself might be a sign of regulatory failure. Only Private Eye had the guts to call a spade a spade – “Gordon Brown promised to increase regulation to deal with collapsing financial institutions, but his biggest move so far is a massive decrease in regulation” suspending normal competition and takeover rules for Lloyds and or Santander. Yet as The Economist points out, “In a world in which big financial firms were allowed to go broke, many of these [regulatory] flaws would matter little.” [“Northern Rock: Who Regulates The Regulators?”, 29 March 2008, pages 41-42]

Regulation has caused overly-large dangerous banks. Regulation creates barriers to entry, promotes the large over the small, and reduces competitive variation. Too big to fail means too big to regulate.

Everyone has their favourite fixes (including me – changes to credit market structures, to credit rating agencies, to auditing, to accounting, to regulation, to risk management, and fundamentally, to competition). Looking back over the past two years, it is apparent that everyone has stumbled and bumbled from incident to event to problem to fix, yet almost all have failed to separate temporary fixes from permanent solutions. Permanent solutions need permanent questions, such as “how would we know when the financial system is working?”

The Credit Crunch is not amenable to quick fixes but, in today’s world of “keep-it-simple-stupid” bullet points, some high-level conclusions include:

  • too big to fail is too big to regulate – financial services is a bit special (so are pharmaceuticals, defence, electricity, air travel, shipping, water, …), but the fundamental regulatory tool in all markets is competition and we need to increase competition in financial services, not reduce it;
  • increases in regulation reduce diversity – a healthy financial services ecosystem should exhibit diversity, yet society appears to over-value presumed economies of scale in financial services;
  • less regulation is just as important as better regulation – what we have here is a failure to regulate, but more regulation is not a measure of success;
  • government intervention displaces private sector investment, as a multiple – the sooner government activity and funding of financial services returns to a minimal level, the sooner longer-term reforms can begin.

I would urge all those embarking on financial services reform to have answers to “how would you know when the financial system is working?”, i.e. what is the desired outcome. Some of those answers might be “when a 20 year old can safely enter into a financial structure for retirement” or “when we can sensibly finance a forest” – sustainable financing over 75 to 100 years, not just quickly flipped transactions. Given recent events, the financial system, if not broken, reveals itself to be incapable of dealing with the long-term. Yes, regulation must change, but moreover I would encourage research into the idea of Long Finance.

I do believe in the power of competitive markets to make the world a better place. I equally believe that markets are social tools requiring design and oversight to meet their objectives. Still you must vote against the motion, for sane discussion in the City, even from those of you who, like me, think that our industry is culpable. Human nature means that competition works, and other regulation must be limited, whatever lies for children politicians and journalists want to sell. Let’s be The City. Tell it like it is – first competition, then better regulation, but certainly not more.

[ENDS]

Result:

The opening vote was 30% in favour of the motion, 30% against the motion and 40% undecided.

The closing vote was 39% in favour of the motion and 61% against.

Yes, Michael and David won.


Supplementary information from Wikipedia:

“Between 1980 and 1994 more than 1,600 banks insured by the Federal Deposit Insurance Corporation (FDIC) were closed or received FDIC financial assistance.

From 1986 to 1995, the number of US federally insured savings and loans in the United States declined from 3,234 to 1,645. This was primarily, but not exclusively, due to unsound real estate lending.

The market share of S&Ls for single family mortgage loans went from 53% in 1975 to 30% in 1990. U.S. General Accounting Office estimated cost of the crisis to around USD $160.1 billion, about $124.6 billion of which was directly paid for by the U.S. government from 1986 to 1996. That figure does not include thrift insurance funds used before 1986 or after 1996. It also does not include state run thrift insurance funds or state bailouts.

The U.S. government ultimately appropriated 105 billion dollars to resolve the crisis. After banks repaid loans through various procedures, there was a net loss to taxpayers of 40 billion dollars by the end of 1999.”

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